In 125 stocks, the earnings growth required was lower than the growth rate achieved in the past five years. These stocks accounted for only about 53 per cent of the market capitalisation of stocks. Examples are Moser Baer, Garden Silk Mills, Bayer ABS, Asahi India Glass, Ballarpur Industries, Fag Bearings, ONGC, Colour-Chem, Hero Honda and Swaraj Mazda.

Similarly, in 120 stocks, the earnings growth required was lower than the sustainable growth rate.

These stocks formed 34 per cent of the market capitalisation of stocks. Examples are Kochi Refineries, Apollo Tyres, West Coast Paper Mills, Swaraj Mazda, DCM Shriram Consolidated, Bayer India, Dredging Corporation, India Glycols, Indian Oil Corporation and India Nippon Electricals.

Thus, for a substantial market segment, the earnings growth required to deliver nominal returns is either higher than what was achieved in the past or is higher than their sustainable growth rate. Evidently, only a robust economic recovery could help these companies achieve such growth.

Cash flow factor

It is not enough for companies to achieve growth in earnings alone. What the market values is growth in cash flows. For the set of 300 companies, the required cash flow growth rate is about 20 per cent annually over the next five years.

A compounded average growth rate of 20 per cent may not be difficult to achieve if base earnings grow at about 15 per cent and such growth is achieved by sweating existing assets more. However, if earnings growth requires sizeable capital expenditure, companies may fall substantially short of the required growth in cash flows, leading to a slide in the stock price.

In this backdrop, investors need to be wary of companies whose cash flow growth has been consistently lower than earnings growth in the past.

For instance, in a number of companies, the average cash flow in the past five years is 30 per cent or less of their average profits. Such companies include National Aluminium, Nirma, Cipla, Mahindra & Mahindra, Zee Telefilms, Punjab Tractors, Neyveli Lignite, Gujarat Narmada, Escorts and Apollo Tyres.

If the valuation levels of these stocks are to be sustained, the companies need to break from the past, even in terms of growing their cash flows. On the contrary, valuations will be on sounder footing in companies whose average cash flow growth has kept pace with that of earnings growth. Instances are Indian Oil Corporation, ITC, Tata Steel, Hero Honda, Grasim Industries, Great Eastern Shipping, Bharat Electronics, Asian Paints, Ingersoll Rand and Kirloskar Oil Engines.

Hinge on recovery

Evidently, the numbers indicate that the broad-based rally will not be compatible with the fundamentals of the listed stocks. The required earnings growth and cash flow growth are not high. However, they may still be difficult to achieve for a number of companies. So, there is no justification for a further across-the-board rise in share prices. Only a selective rally in stocks appears warranted.

However, markets are prone to excesses. As such, before the Budget is presented, stock prices may rally further. However, that will only increase the possibility of decline in stock prices post-Budget and should thus be viewed as an opportunity to sell stocks.

In addition, even if there is no rally from present levels, investors may find it difficult to earn reasonable returns if they do not practise stock selection. Investors need to be wary of stocks whose required earnings growth is incompatible with past performance.

Such companies include Hikal, CESC, Tata Telecom, Century Textiles, Hindustan Oil Exploration, Whirlpool of India, ITC Hotels, Gillette, Hindalco and EIH. Investors also need to be wary of stocks whose required earnings growth is higher than their sustainable earnings growth. These include Titan Industries, Sesa Goa, Madras Cements, Indian Hotels, Orchid Chemicals, BSES, Tata Motors, Elgi Equipments, ACC and Bharat Earth Movers.

Finally, investors who put money into stocks now must pray for a robust rise in the economic growth rate. If the expected rise in growth rate does materialise and is sustained over the next three to five years, stock prices will deliver returns, even from their present highs.

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